Commercial Real Estate Debt: An Insurance Perspective

June 2020 / Investment InsightsThe basic structure of a commercial real estatelending agreementThe most common structure in CRE lending is set up as aloan to a property-owning special purpose vehicle (SPV) operated by a sponsor. The loan is repaid by the cash flowsgenerated by the property. A basic CRE lending structure isoutlined in Figure 4. Historically, CRE debt was mainly provided in the form of whole loans. However, from the end ofthe 1990s more granular risk profiles started evolving andloans were broken down into senior and subordinated orjunior loans (sometimes referred to as ‘mezzanine loans’). Inthe case of junior loans, there will be an additional subordinated SPV acting as the junior borrower. This is typically aholding company, 100% owned by the sponsor, but sittingtwo or three levels higher than the property-owning SPV.The junior loan to the holding company is serviced from theexcess income generated by the property, but only after servicing the senior loan. The order of debt repayment andranking of security between the senior lenders and the juniorlenders is usually governed by an intercreditor agreement.FIGURE 4. BASIC CRE LENDING STRUCTUREreal estate financing is in the form of senior debt, whichranks in priority to all other financial obligations of the borrower. However, the market offers the opportunity to movefurther down in the seniority scale, investing in subordinatedor junior debt, and receiving a yield premium in compensation for the increased risk. Junior debt sits between seniordebt and equity, and it is therefore subordinated in priority ofpayment to senior debt, but ranks ahead of preferred stocksor equity.Loan-to-value (LTV)The LTV expresses the ratio of the outstanding loan value tothe value of the underlying property. This ratio is one keymetric to assess the lending risk. Higher LTVs leave asmaller (equity) buffer in the event of a decline in propertyvalue. The credit quality decreases as leverage increases.Senior CRE loans typically have an LTV below 65% whilejunior CRE loans usually sit at an LTV between 65% and85%, taking incremental risk behind the senior loan. Thismeans that a fall in property value in excess of 15% couldpotentially result in a capital loss for the junior lenderwhereas the senior lender would only be subject to a potential capital loss should the property value decline by morethan 35% (see Figure 5).FIGURE 5. TYPICAL CAPITAL STACK IN CRE FINANCING120%Loan-to-value (LTV)100%80%60%40%20%0%As of: June 2020; source: DWS International GmbHBesides the entities mentioned above, CRE lending agreements typically involve various other parties including an arranger for syndicated loans as well as a facility and securityagent (on the lender side) and an asset or property managerand guarantor companies (on the borrower side).Key considerations for investing in commercialreal estate loansCompared to public corporate bonds, private CRE lendingstructures are typically more complex, with various factorsthat need to be taken into account.SeniorityDebt investors rank senior to equity investors. This meansthat equity investors receive the remaining cash flows fromprojects, only after deducting operating costs and incomeused to service debt investors. Today, the majority of privateTotalinvestmentSenior LoanScenario AJunior LoanScenario BScenario CEquity provided by borrowerScenario A - Property value rises by 10%Equity gain for borrower of 67%Scenario B - Property value declines by -10%Equity loss for borrower of -67%Scenario C - Property value declines by -20%Equity loss for borrower of -100% and loss for junior lender of -25%As of: June 2020; source: DWS International GmbHSecurityCRE debt is usually secured against the underlying property. Examples of security in senior CRE loans include a firstranking mortgage over the property, pledge over the sharesof the property-owning SPV, account pledge, rent assignment and duty of care. Common types of security in juniorloans include a second ranking mortgage over the propertyas well as share pledges on the subordinated SPV.The information herein reflects our current views only, are subject to change, and are not intended to be promissory or relied upon by thereader. Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical modelsor analyses, which might prove inaccurate or incorrect. DWS International GmbH. As of: 19 June 20203

June 2020 / Investment InsightsCovenantsCRE debt includes agreements and conditions between theborrower and lender. These are agreed as a condition ofborrowing, with the purpose of supporting the condition ofthe lender, mitigating the risk of incurring credit losses andacting as an early warning mechanism to lenders. A breachof covenant usually allows creditors to demand repaymentof the loan, should the borrower be unable to remedy thebreach during a cure period. There are two basic types ofloan covenant:̲ Structural covenants: Impose restrictions on certain activities such as debt issuance, asset sales or other transactions̲ Financial covenants: Establish thresholds for specific financial metrics. Examples include a maximum loan-tovalue (LTV), a minimum interest rate coverage ratio (ICR)or a minimum debt-service coverage ratio (DSCR). Financial covenants are typically tested on each interest payment dateFIGURE 6. RISK CATEGORIES OF PROPERTY INVESTMENTSCoreInvestments in prime assets with relatively high, long-termincome streams and strong tenants covenants in more mature, transparent and liquid marketsCore PlusInvestments in properties requiring a higher degree of asset management than Core assets, located in prime andsecondary submarkets of major metropolitan areas andprime sub-markets in secondary cities. Characteristics caninclude partial current vacancy, near-term lease expirywhere rental reversion is possible and tenant reconfigurationValue AddedInvestments in properties that fall between the two extremes of Core and Opportunistic in terms of return targetsand leverage but require a higher degree of active management and risk appetite than Core Plus. Characteristicsinclude asset repositioning and development, and relianceon market growthOpportunisticInvestments in properties requiring capital and intensiveasset management to reposition them to appeal to Core investor demand, including distressed debt investments andopportunities arising from government and corporate outsourcing and restructuringAs of: June 2020; source: DWS International GmbHType of collateral propertyProperty investments can be broadly categorised into fourcategories, each of them providing a different level of riskand yield opportunity (see Figure 6). Additionally, the occupancy rate of the property is one key metric that is constantly monitored. For senior CRE loans, DWS typically defines a minimum occupancy rate of 70% but prefers ratesabove 90%.Loan sizeLending against commercial property requires a detailed internal credit assessment and due diligence process. For thisreason, loans above EUR 50 million are typically preferredby institutional investors.Loan termThe vast majority of CRE loans are underwritten for between four and seven years. However, due to a growingpresence of insurers and pension funds in the lending market as well as due to low interest rates, the share of longerdated senior loans has increased in recent years.RepaymentTypically depending on the lease profile, CRE loans can beamortising or can have a bullet structure. In an amortisingstructure, the LTV reduces during the term of the loan, reducing the refinancing risk. Some lenders may prefer toavoid prepayment options due to difficulties with liabilitymatching and hedging. Hence, prepayments might not beallowed or will be subject to an additional fee.Interest rateThe majority of CRE loans are priced according to an interest rate margin over a reference rate such as EURIBOR orLIBOR. In many cases, the floating rate of the coupon isfloored at zero so that the lender receives the spread as aminimum. Interest is typically paid on a quarterly basis.Credit ratingThe majority of outstanding private real estate debt is notrated by an external rating agency. However, some lendersor asset managers have internal ratings processes for theloans as part of their due diligence process.The information herein reflects our current views only, are subject to change, and are not intended to be promissory or relied upon by thereader. Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical modelsor analyses, which might prove inaccurate or incorrect. DWS International GmbH. As of: 19 June 20204

June 2020 / Investment InsightsThe table below provides a comparison between CRE loansand corporate bond investments.FIGURE 7. COMMERCIAL REAL ESTATE LOANS VS. CORPORATE BONDSCRE LoanCorporate BondCouponMajority floating with zerofloorMajority fixedSecurityTypically collateralized bythe underlying propertyTypically unsecured with nodedicated collateralRatingTypically not rated by an external rating agency but internal rating possibleTypically rated by an external rating agencyComplexityRequires detailed due diligence on the loans termsand the collateral propertyTypically high level of standardization and availability ofpublic credit ratingsLegal tenorMajority 4-7 years but longer Typically 5-15 yearsdurations possibleLiquidity1-3 months to loan saleDaily tradingValuationLoan valuation on a monthlybasis. The underlying property is typically only reviewed by external valuerson an annual basis.On a daily basis(secondary market)Major riskfactorsProperty risk, interest raterisk, inflation risk, liquidityriskCorporate credit risk, interest rate risk, inflation riskAs of: June 2020; source: DWS International GmbHCommercial real estate loans under stressedconditionsAs a private asset class, CRE loans are typically characterised by a low degree of volatility. Nevertheless, the value ofCRE loans also shows sensitives to underlying market conditions. The margin of a senior CRE loan, and hence thevalue of the loan, is mainly driven by four factors:̲ Capital costs: These costs are linked to the Basel III andIV capital requirements for CRE loans and typically varybetween 0.30% and 0.40% for senior CRE loans.̲ Operating costs: These costs are linked to banks’ operating costs to originate and manage CRE loans. They typically vary between 0.25% and 0.35%.̲ Liquidity costs: These are the financing costs of banksand financial institutions in the bond market.̲ Credit costs: These costs are mainly linked to the marketvalue risk of the underlying property and vary with theloan LTV.Of these four factors, only liquidity and credit costs showsignificant sensitivities to market conditions.For example, during the 2007/2008 global financial crisisand the 2012 crisis, bank senior margins (measured by theMarkit iBoxx Banks Senior Index) increased by approx.2.5%. Additionally, long-term financing costs increased by0.05% p.a. on average. Hence, the overall liquidity costs fora given loan increased by 2.5% 0.05% * loan duration during these periods.Credit costs are most sensitive to changes in LTV. Based onDWS’ internal option-based loan pricing model, we estimatethe margin sensitivity to LTVs at around 1% per 10% of LTVincrease for all loans with a margin of above 2%. This sensitivity is similar across all asset qualities.Based on these assumptions, DWS ran a simulation to assess the impact of the global financial crisis of 2007/2008 ona representative pan-European senior CRE loan portfoliowith an initial LTV of 52%. Using historical data provided byProperty Market Analysis (PMA), the portfolio’s average LTVwould have increased to 69% resulting in an increase of thecredit margin of 1.7%. Additionally, given an average portfolio duration of 3.6 years, the liquidity margin would haveincreased by 2.7%. Hence, the global financial crisis scenario results in an increase of the discount margin by 4.4%, which translates into a decrease of the portfoliovalue by -18.9%.Treatment under Solvency IIUnder the Solvency II standard formula, senior CRE loansare subject to a Solvency Capital Requirement (SCR) for thespread risk, interest rate risk and potentially currency risk.The interest rate risk we will not be further discuss in thissection as it is closely related to liabilities which are uniquefor each insurance company and business line. The sameapplies to potential currency risks. We assume that anyopen FX exposure is unwanted and is hence eliminated either via rolling FX forwards or cross-currency swaps. Therefore, the focus of this section is on the SCR for the spreadrisk, which is determined by the credit rating and duration ofloan (applying the SCR standard model).CRE loans usually do not carry credit ratings from ExternalCredit Assessment Institutions (ECAI). Hence, we mainlysee two approaches for determining the spread risk SCR forCRE loans.Standard approachThe default approach is to apply Article 176 paragraph 4(Delegated Regulation 2015/35) which defines the spreadrisk SCR for unrated bonds and loans as a function of duration. The spread SCR for unrated bonds and loans is slightlyhigher than for BBB-rated bonds and loans but significantlylower than for instruments in the sub-investment grade segment (see Figure 8).The information herein reflects our current views only, are subject to change, and are not intended to be promissory or relied upon by thereader. Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical modelsor analyses, which might prove inaccurate or incorrect. DWS International GmbH. As of: 19 June 20205

June 2020 / Investment InsightsFIGURE 8. SOLVENCY CAPITAL REQUIREMENT FORUNRATED LOANSSpread Risk SCR50%40%30%20%10%(2) Collateral is of sufficient liquidity and stable in value:There is typically a market for all non-special purpose property. However, liquidity is determined by many factors suchas property type (e.g. residential, office, hotel, etc.), location,condition, transaction size, local market dynamics, time andcosts to transact. For example, the Swiss Financial MarketSupervisory Authority (FINMA) has specified which type ofproperty they consider as liquid and less liquid (see FINMACircular 2016/5 which defines investment rules for tied assets of Swiss insurers).0%1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20Modified DurationUnratedBBBBBAs of: June 2020; source: DWS International GmbHSome insurers rate their CRE loans internally or may leverage internal ratings provided by asset managers. For example, DWS provides internal ratings based on an approved internal rating model, validated by a highly reputable thirdparty. Depending on the assets, the rating usually range between A to BBB for senior CRE loans. Within the Own Riskand Solvency Assessment (ORSA) insurer may be able toleverage those internal ratings for their internal process.Collateral approachSenior CRE loans are typically backed by property as collateral. Compared to unsecured loans, this results in a lowerrisk for the insurer. However, in contrast to residential mortgage loans, senior CRE loans do not attract a favourablecapital charge by default. Nevertheless, following Article 176paragraph 5, a reduction in the capital charge of up to 50%may be achieved if the underlying property meets the collateral criteria set out in Article 214. The general tone of Article214 may suggest that only bonds can serve as collateral.However, this interpretation can vary across national insurance supervisors, as DWS has experienced in many conversations across Europe. When applying Article 214 to theunderlying property, we believe that the following criteria aremost crucial and require a deeper assessment.(1) Insurer has the right to liquidate or retain the collateral in a timely manner given a default, insolvency orbankruptcy: This condition should not be a problem inWestern European countries or the US. Security packagesof senior CRE loans are typically structured in a way suchthat the investor has the right to liquidate or retain the underlying property in the case of default. The timing of the enforcement process varies by jurisdiction. The enforcementprocess is especially (time-) efficient in the UK and Luxembourg.Liquid property:̲ Residential: Single-family house, multi-family house andcondominium ownership̲ Commercial: Office and administrative buildings̲ Mixed usageLess liquid property:̲ Building land̲ Buildings under construction̲ Production sites, warehouses, distribution centers̲ Sports facilities̲ Shopping centers outside the city center̲ Hotels, restaurants̲ Retirement and nursing homes̲ School buildings̲ Character/luxury properties, holiday apartments andhouses̲ Joint property̲ Objects in need of renovation with contaminated sites̲ Property in foreclosureThis list has no legal relevance for Solvency II regulated entities but might be used as guidance.(3) No material correlation between credit quality of thecounterparty and the value of the collateral: For this requirement, EIOPA provides the following guidance: “If abond issuer only owns one asset and that asset serves ascollateral to the benefit of bond holders, it must be concluded that there is material positive correlation between thecredit quality of the issuer and the value of the collateral.This holds also true for e.g. a bond issuer owning only onecommercial real estate with tenants on long leases, as thecredit quality of the bond issuer will depend on the samefactors as the market value of the property, and these will include the factors such as: location, market prices in thearea, contract terms, lease duration, tenant credit qualityetc.”The information herein reflects our current views only, are subject to change, and are not intended to be promissory or relied upon by thereader. Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical modelsor analyses, which might prove inaccurate or incorrect. DWS International GmbH. As of: 19 June 20206

June 2020 / Investment InsightsFIGURE 9. SOLVENCY CAPITAL REQUIREMENT FOR COLLATERALISED COMMERCIAL REAL ESTAE LOANS40%35%30%Spread Risk SCRIf the underlying property meets all relevant collateral requirements, the reduced spread risk SCR for the loan is determined based on following parameters:̲ Market value of the loan̲ Risk-adjusted value of the loan: Value of the loan after applying the spread stress for unrated loans̲ Risk-adjusted value of the property: Value of the propertyafter applying the Solvency II standard formula stress forproperty of 25%̲ Modified duration25%20%15%10%5%0%Given these input parameters, there are three different scenarios with a potential reduction in SCR ranging from 0% to50%.Scenario I – Reduction by 50%In this scenario, the risk-adjusted value of the property isgreater or equal to the market value of the loans. This allows to reduce the spread risk SCR for unrated CRE loansby 50%. The risk-adjusted value of the property is calculatedby applying the Solvency II standard formula stress for property of 25%. As a result, all CRE loans that carry an LTV ofbelow 75% can receive a reduction in spread risk SCR of50%.Scenario II – Reduction by 0% to 50%Here, the risk-adjusted value of the property is smaller thanthe market value of the loan but greater than the risk-adjusted value of the unrated loan. In this case, the spreadstress is an interpolation between Scenario I and a fixed factor that depends on the LTV, capped by the unrated spreadstress:𝑆𝐶𝑅 50% (𝑆𝐶𝑅 𝑈𝑛𝑟𝑎𝑡𝑒𝑑 (1 𝑀𝑉 𝐶𝑜𝑙𝑙𝑎𝑡𝑒𝑟𝑎𝑙 ))𝑀𝑉𝐿𝑜𝑎𝑛SCR Spread risk SCR for the loan with collateralSCRUnrated Spread risk SCR for the unrated loan without collateralMVCollateral Market value of the collateral property stressed with 25%MVLoan Market value of the loanScenario III – No reductionThe risk-adjusted value of the collateral property is smallerthan the risk-adjusted value of the loan. In this case, therewill be no reduction in SCR and the full SCR for unratedloans applies.It is important to mention that the collateral approach onlyapplies to unrated loans. For loans rated by an ECAI, thestandard approach for bonds and loans applies with thecredit rating as one major input factor. The basic assumption is that the collateral relationship is already properly reflected in the credit rating.1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20LTV 75%LTV 85%DurationLTV 95%UnratedAs of: June 2020; source: DWS International GmbHTreatment under the Insurance Capital StandardsFrom 2025, all Internally Active Insurance Groups (IAIGs)are expected to adopt the Insurance Capital Standards(ICS), a global risk-based solvency framework developed bythe International Association of Insurance Supervisors(IAIS). Besides its immediate relevance for global insurancegroups, the ICS are also used as a blue print for the solvency regimes in various Asian countries. For example, theinsurance regulators in Japan, Korea and Taiwan are currently considering to adopt the ICS or a modified version ofit as their local solvency regimes.Under the latest ICS Version 2.0 published in March 2020,mortgage loans are treated as a separate risk category under the credit risk module. For performing commercial mortgage loans for which the repayment depends on the property income, the risk charge is calculated using one of threemethods depending on the data availability:Method 1: The risk charge is based on the ICS CommercialMortgage (CM) category as

tween life and non-life insurers (see Figure 2). While both types of insurer invest mainly in private markets, life insurers tend to do so in the form of debt – such as commercial real estate (CRE) loans or residential mortgages – while non-life ins